NCPA - National Center for Policy Analysis

"Grade Inflation" and The Stock Market

March 6, 2002

For some time, there has been a sort of "grade inflation" going on in the recommendations of financial analysts, says Bruce Bartlett.

  • Recommendations to sell a stock have been virtually eliminated.
  • A recommendation to "hold" a stock is now tantamount to saying sell.
  • When an analyst actually wants to say "hold" he now says "buy."
  • And when he really wants someone to buy the stock he now says it is a "strong buy."

There are several reasons for this trend. Most financial analysts work for investment banks that underwrite new stock issues. Although they are supposed to be shielded from pressure to favor the stocks of the investment bank's clients, it cannot be eliminated.

Although analysts are seldom actually fired for making politically incorrect recommendations, they have long known that they can pay a price. Companies that they follow may cut them off and make it hard for them to get information about them. Their employers may give larger bonuses to analysts whose recommendations bring in underwriting business and demote those who anger potential clients.

This has created a bias within financial markets that helped hide Enron's problems from investors. As a consequence, investors are often left thinking there is little difference between a stock that simply will trail the Standard & Poor's 500 index and one in danger of imminent collapse.

Arthur Andersen and other accounting companies have rightly been criticized for having conflicting interests when they both do a company's books and have large consulting contracts with it as well.

Financial analysts have the same problem when their employers solicit underwriting business. The solution is the same in each case: total separation of functions.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, March 6, 2002.


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